REPORT ON THE OBSERVANCE OF STANDARDS AND CODES (ROSC) CONTENTS. EXECUTIVE SUMMARY i SUMMARY OF RECOMMENDATIONS vi I. BACKGROUND 1

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized REPORT ON THE OBSERVANCE OF STANDARDS AND CODES (ROSC) Paraguay ACCOUNTING AND AUDITING June 1, 2006 CONTENTS EXECUTIVE SUMMARY i SUMMARY OF RECOMMENDATIONS vi I. BACKGROUND 1 II INSTITUTIONAL FRAMEWORK FOR CORPORATE SECTOR ACCOUNTING AND AUDITING 4 A. Statutory Framework 4 A.1 Accounting 5 A.2 Auditing 6 A.3 Publication of Financial Statements 10 A.4 Internal controls 10 B. The Accounting and Audit Profession 11 C. Professional Education and Training 12 D. Setting Accounting and Auditing Standards 13 E. Ensuring Compliance with Accounting and Auditing Standards 13 III. ACCOUNTING STANDARDS 15 A. Standards as Defined in the Statutes 15 B. Compliance with Standards 18 IV. AUDITING STANDARDS AND PRACTICES 20 V. PERCEPTIONS ON THE QUALITY OF FINANCIAL REPORTING 22 VI. FINDINGS AND RECOMMENDATIONS 23 This report was prepared by the World Bank on the basis of a diagnostic review carried out in Asunción between October 2005 and March 2006, with the participation of the Inter-American Development Bank (IDB). The task team was led by Henri Fortin (LCSFM) and also included Orlando Ferreira (LCSFM), Joanne Givens (LCSFM), and Norberto Diamanti (IDB). Jamil Sopher provided assistance with regards to quality review. The task team also received the support of the World Bank Country Management Unit (LCC7C) in Asunción, Buenos Aires and Washington. The review was conducted through a participatory process involving various stakeholders and led by the Government of Paraguay. This assessment was cleared for publication by the Ministry of Finance on December 28, 2006.

2 CURRENCY: PARAGUAYAN GUARANI (PYG) 1 US$ = 5,870 PYG as of May 15, 2006 ABBREVIATIONS AND ACRONYMS AFD AIC BCP BNF BVPASA CAC CAP CGR CNV DGGC DPL FDI FIN FSAP GAAP GAAS GDP IAS IASB IDB IES IFAC IFRS INCOOP IMCP ISA MoF MERCOSUR MIF NSC ROSC SIB SIS SME SOE SSET Public Financial Development Agency Interamerican Accounting Association Central Bank of Paraguay National Development Bank Asunción Stock and Commodities Exchange Credit Cooperative Country Action Plan Auditor General of the Republic National Securities Commission Large Taxpayers Office Development Policy Lending Foreign Direct Investment Financial Companies - Financieras Financial Sector Assessment Program Generally Accepted Accounting Principles Generally Accepted Auditing Standards Gross Domestic product International Accounting Standards International Accounting Standards Board Inter-American Development Bank International Education Standards for Professional Accountants International Federation of Accountants International Financial Reporting Standards National Institute of Cooperatives Mexican Institute of Public Accountants International Standards on Auditing Ministry of Finance Southern Cone Common Market Multilateral Investment Fund National Steering Committee Report on the Observance of Standards and Codes Superintendence of Banks Superintendence of Insurance Small and Medium Enterprise State-Owned Enterprise Tax Administration Paraguay ROSC Accounting & Auditing

3 EXECUTIVE SUMMARY 1. This report provides an assessment of Paraguay s corporate accounting and auditing practices, using International Financial Reporting Standards (IFRS) and International Standards on Auditing (ISA) as benchmarks, and drawing on international experience and good practices in those fields. The main purpose of this ROSC is to assist the Government of Paraguay and stakeholders in strengthening and improving the financial reporting regime in the country. The development objectives these efforts support are: (a) improving the business environment in Paraguay and making it more attractive for domestic and foreign direct investment, (b) enhancing financial transparency in the corporate sector; and (c) enhancing opportunities for greater economic integration with the region and the world. 2. In 1989, Paraguay began a slow and difficult road toward democracy after emerging from 35 years of authoritarian rule. The former regime left a complex legacy of weakened institutions, a dwindling stock of human capital and a severe lack of transparency in many of the country s public and private sector institutions. Economic performance during these last 16 years has been weak, showing negative real growth in any five year period since The country s economic activity still relies heavily on agriculture, hydroelectric generation and informal trade, mainly with Argentina and Brazil. The agriculture sector generates 90 percent of exports and provides a third of the jobs at the cost of great volatility due to variations in international prices of commodities and climatic conditions. Poverty and inequality remain defining characteristics of Paraguay s economic and social landscape. According to a 2004 survey, 39.2 percent of the population lived below the national poverty line. 4. To achieve the goal of equitable and sustainable development, Paraguay s private sector must assume a leadership role. Achieving this goal will be a difficult challenge. According to the 2006 World Bank Doing Business Indicators, Paraguay ranked below 120 out of 155 countries surveyed for indicators measuring time required to start a business and rigidity of employment. The 2005 Global Competitiveness Index published by the World Economic Forum ranked Paraguay 102 out of 117 countries and 20 out of 21 in Latin America and the Caribbean. This scenario is further exacerbated by the perception both inside and outside the country of pervasive corruption and lack of rules. International surveys and research conducted at multilateral institutions have highlighted this issue. A recent example is the Country Policy and Institutional Assessment carried out in 2005 by the World Bank. 5. Another major impediment for private sector-led growth in Paraguay is the limited availability of financial resources for investment. Net inflows from foreign direct investment averaged 2 percent of GDP from 2003 to 2005, which is a marked improvement from previous years, but remains below regional levels. As in most of Latin America, savings are mostly shortterm. During the last 10 years, average maturities of deposits have not exceeded 18 months in Paraguay, which limits the capacity of financial institutions to lend for purposes beyond working capital. Adding to this, the environment has not been conducive to lending and banks have limited their operations, concentrating on large corporate clients in the export sector. By December 2005, financial institutions showed very low ratios of loans to deposits (close to 58 percent), and placed 45 percent of their resources in Central Bank issued papers. 6. A new government took office in August of 2003, elected on a platform of fighting corruption and reforming the state. So far, the administration of President Nicanor Duarte Frutos has been able to deliver on the reform of tax and customs legislation and has kept government spending under control. Economic conditions have improved in the last three years Paraguay ROSC Accounting & Auditing Executive Summary i

4 with real GDP growth averaging 1.1 percent. The foreign currency component of bank deposits dropped from 70 percent in 2001 to 55 percent in 2005, indicating renewed confidence in the local currency; the stock market, although still small, has tripled its volume of operations; and interest rates both in foreign and local currency continue their downward trend. 7. Developing a high-quality corporate financial reporting regime can help harness Paraguay s potential, improve access to financial resources, and boost the country s competitiveness and global integration. Additionally, the existence of clear rules that are complied with and enforced, coupled with adequate availability and disclosure of high-quality financial information can help dispel the negative perception about lack of transparency in the country s business community. This report will focus on Paraguay s challenging road ahead toward achieving these goals. Paraguay s statutory framework for accounting and auditing 8. The principal finding of this ROSC is that Paraguay has an incomplete, fragmented and loosely enforced statutory framework for accounting and auditing. Outside the financial, cooperative and, to a lesser extent, state-owned sectors, (referred to as supervised sectors) there are no legally sanctioned standards and no enforcement mechanisms. Only one fourth of the largest 200 companies in the country belong to one of these sectors. 9. Recently enacted tax law empowers the Ministry of Finance (MoF) to adopt standards for accounting and auditing. The Ministry may impose International Financial Reporting Standards (IFRS) or other Generally Accepted Accounting Principles (GAAP) on Paraguayan taxpayers, provided they would not conflict with tax regulations. The law also mandates external audits for companies with revenues above one million US dollars, however, to put this into practice, the tax administration is required to establish a registry for external auditors and set auditing standards. As of the date of this report, none of these provisions had been implemented. 10. Within the supervised sectors, the quality of standard setting, compliance with standards and supervision of compliance is uneven and the regulation in place is fragmented. The Banking Superintendency (SIB) appears as the strongest regulator. As in many other countries, banking regulation has a prudential focus and differs significantly from IFRS. The National Securities Commission s accounting standards although based on international standards, date back to 1992 and have not been updated. The insurance and cooperative sectors are facing new sets of accounting rules that become effective in It is too early for a full assessment, but it is clear that in both cases the new statutes are significant improvements over existing ones. State-owned enterprises are subject to the supervision of the Auditor General of the Republic (CGR); but CGR s role is mostly focused on oversight of procurement processes and investigation of fraud allegations. 11. All five regulatory agencies maintain a separate registry for external auditors, causing duplication of efforts. Each agency has its own set of rules, which range from highly detailed, such as those issued by SIB or the Superintendency of Insurance (SIS), to broad guidelines, as is the case with the National Institute of Cooperatives (INCOOP). These different registries, coupled with the possibility of a sixth registry likely to be created by the tax administration, impose an unreasonable burden on audit firms. A cross-check of membership in each respective registry shows that 26 out of 34 companies belong to at least three. External auditors must periodically renew these memberships, through processes that are mostly redundant. More importantly, there is no formal process of communication between registries, so Paraguay ROSC Accounting & Auditing Executive Summary ii

5 it is possible for an auditor suspended in one registry to be present in another. These registries are intended to regulate professional practice, provide a basis for quality control, and set minimum professional standards, including a requirement for previous experience and adequate institutional capacity for audit firms and individual practices; none of these regulations requires professional examination or continuing education however. Improving the quality of professional practice 12. University curricula in accounting and auditing in the country are not subject to any type of minimum requirements, and efforts should be made towards harmonization with the International Federation of Accountant s (IFAC) educational standards. Establishing educational standards is in line with international benchmarks is all the more important since, with the exception of supervised sectors, a college degree in accounting is the main and often the only requisite for a professional accounting or auditing practice. The team interviewed five universities that offer accounting degrees and found great interest in the improvement of accounting education but, as is often the case; the lack of resources technical and financial is a major impediment. 13. The accounting profession in Paraguay is organized through voluntary associations. The Paraguayan College of Accountants, (Colegio) was established in 1916 and has close to 2,100 members. Its Professional Board adopted IFRS and ISA in 2003 but, without legal backing, the Colegio s resolutions are viewed only as guidelines by practicing accountants and auditors. The Colegio organizes annual conferences and offers regular courses and seminars on professional issues. In March of 2005, over 200 professionals formed a new organization, the Paraguayan Council of Public Accountants, (Consejo). The Consejo has recently published a Code of Professional Ethics and a volume of Auditing Standards. 14. Efforts made by the profession to set, disseminate, and enforce the use of accounting and auditing standards and a code of ethics by their members have met limited success. The professional associations do not have enough resources and although highly qualified professionals have volunteered valuable time to achieve these goals, such an approach lacks sustainability. International standards for accounting and auditing are constantly evolving. Adoption of these standards requires continued monitoring and evaluation before they can be implemented in any country. The task of setting standards is a full time occupation, and the same can be said for the tasks of enforcing standards and effectively imposing a code of ethics for professional practice. Even with significant strengthening and increased resources, it is difficult to envision the professional associations in Paraguay assuming all of these roles. This report endorses the alternative of a specialized institution with ample participation of the profession and other relevant sectors. 15. Implementing a high-quality financial reporting regime will require significant efforts in the areas of professional education and capacity building. Three main sectors should be targeted for action: (i) in the academic sector, university curricula for accounting and auditing must be updated and harmonized with IFAC s education standards. Professors must be trained to effectively deliver better quality courses; (ii) in the regulatory sector, supervisors charged with enforcing new regulation will require training; and (iii) practicing accountants and auditors must significantly improve and expand current efforts directed at continuing professional education. Paraguay ROSC Accounting & Auditing Executive Summary iii

6 Transparency in financial reporting 16. Paraguay s statutory framework does not require the publication of audited financial statements by any public-interest entity, except listed companies. Publication requirements exist only for some supervised companies, and they differ significantly from one sector to another. CNV makes the financial statements of listed companies readily available on its website. Banks, insurance companies and large cooperatives are required to publish abbreviated financial statements in a newspaper. SOEs are not required to publish their financial statements, although some do so voluntarily. There are no publication requirements for non-listed companies. 17. The perception of corruption and lack of rules is one of the major obstacles that Paraguay s corporate sector must overcome to attract domestic and foreign investment. The arguments against publication of financial statements center on the costs involved and the revelation of strategic information to existing or potential competitors. These arguments, although valid, do not take into consideration that enhancing investor and creditor protection is vital to improving the country s business climate, which in turn benefits all. Also, from the point of view of the entrepreneur, availability of good information will help to improve strategic planning and execution of complex business scenarios. Recent developments in the country s stock market show that when given a real choice based on adequate information and the confidence that follows transparency, investors are willing to channel financial resources into the country s companies. Paraguay s private sector must assume leadership for compliance and disclosure. The road ahead 18. The description of Paraguay s statutory framework for accounting and auditing points directly to the need for clear and comprehensive rules. Paraguay s accounting and auditing statutory framework should follow a coherent structure. It must have an efficient standard-setting process and a strong, capable institution to monitor the quality of professional practice and enforce the statutes. 19. Moreover, the report recommends actions toward building capacity within academia, regulatory agencies and the accounting and audit profession. It also includes recommendations in the areas of professional examination and continuing education. 20. Companies, especially those that have public-interest characteristics should be made aware of the potential benefits derived from high quality and transparent financial reporting. Greater awareness is the fastest way to foster disclosure and compliance. 21. Addressing the weaknesses in the accounting and auditing environment and achieving the needed improvements will require a strong involvement of the Government and the contribution of all key stakeholders. The main challenges for in-country stakeholders will be to arrive at the necessary consensus in order to develop an effective Country Action Plan (CAP) and secure the commitment of all involved in its implementation. 22. At the suggestion of the ROSC team, the MoF convened a meeting with representatives of the accounting profession, the five regulatory agencies, the business community, and academia. This meeting was chaired by Minister Bergen and took place on March 3, 2006, during the main mission of the ROSC Accounting & Auditing in Asunción. The team recognized this as a significant step, and in order to give this group the structure and resources required to become the real force behind the proposed reforms, it is the first recommendation of this report that through an official act of the MoF, a National Steering Paraguay ROSC Accounting & Auditing Executive Summary iv

7 Committee (NSC) should be formally established, its terms of reference defined and its members appointed. The membership of the NSC should include the institutions that participated in the aforementioned meeting. The NSC should have a Secretariat equipped with a small staff to be provided by the MoF. All member institutions are expected to contribute significant time to the preparation and monitoring of the CAP. The NSC should also serve to mobilize donor support to carry out the CAP. 23. The ROSC recommendations are summarized in the following table, which presents recommendations in the order in which they appear in the body of report. A second table provides a tentative implementation timeline. Paraguay ROSC Accounting & Auditing Executive Summary v

8 SUMMARY OF RECOMMENDATIONS Action 1. Establish the National Steering Committee (NSC) on Accounting and Auditing, in charge of developing and implementing the Country Action Plan (CAP): a. Through an official act of the MoF, formally establish the NSC, set its terms of reference and appoint its members b. Provide adequate resources to the NSC to enable it to carry out its function effectively c. Formulate and implement the CAP 2. Pass a law to (i) making IFRS and ISA the mandatory accounting and auditing standards in Paraguay and (ii) create a professional oversight body for accounting and auditing. SMEs should be subject under that law to a simplified set of standards based on the international SME standards currently under in preparation. 3. Establish the professional oversight body convening all relevant stakeholders to carry out the following roles: Reference (Para.) a. Setting accounting and auditing standards in the country. 78(a) b. Awarding and revoke professional licenses for accountants and auditors. c. Enforcing auditing and ethical standards including the use of sanctions in cases of non-compliance. 4. Harmonize the regulatory framework for accounting and auditing 72 Responsibility Short-term (within 1 year) MoF (with the support of incountry stakeholders and donors) 73 MoF 78(b) 78(c) a. Develop a certification mechanism for accountants. 79 (a) b. Develop a unified process for accreditation and certification of external auditors. c. Implement publication requirements for all public-interest companies. 79 (b) 79 (c) MoF (with support of NSC membership) NSC (to be transferred later on to Oversight Body) Timing of effective implementation Medium-term (1 to 2 years) Continuing process Continuing process Long-term (3 to 5 years) Paraguay ROSC Accounting & Auditing Executive Summary vi

9 d. Harmonize rotation of external auditors, and extend the current 2- to 3-year term to 5 years. 79 (d) SUMMARY OF RECOMMENDATIONS (CONTINUED) Action 5. Require external audits from all SOEs and create a mechanism to monitor SOE financial reporting. These audited financial statements should be made available to the general public. 6. Update academic curricula in the field of accounting and auditing in line with IFAC s International Education Standards. 7. Undertake a comprehensive effort to build capacity for an improved financial reporting regime in Paraguay: a. Train university professors to effectively implement the reformed curricula. b. Train staff at regulatory agencies to effectively enforce the reformed statutory framework. c. Improve and expand the existing training programs for accountants and auditors. 8. Other long-term actions to be considered: a. Clarify the function of síndico, eliminating any redundancy with the roles of external auditor and audit committee. b. Harmonize regulatory standards with IFRS. c. Make financial statements from all public-interest entities available to the general public. Reference (Para.) Responsibility Short-term (within 1 year) 80 MoF 81 National Accreditation Agency 82 (a) Universities 82 (b) 82 (c) 83 SIB, SIS, CNV, INCOOP, CGR Colegio, Consejo MoF SIB, SIS, CNV, INCOOP MoF/NSC Timing of effective implementation Medium-term (1 to 2 years) Long-term (3 to 4 years) Paraguay ROSC Accounting & Auditing Executive Summary vii

10 ROSC A&A Paraguay Tentative Implementation Timeline Paraguay ROSC Accounting & Auditing Executive Summary viii

11 Color Key Legend High Priority Action Medium Priority Action Low Priority Action Low Priority Action Requires substantial discussion among stakeholders This tentative timetable is indicative and solely intended as input for the preparation of the Country Action Plan Paraguay ROSC Accounting & Auditing Executive Summary ix

12 I. BACKGROUND 1. This review of accounting and auditing practices in Paraguay is a part of the World Bank (WB) and International Monetary Fund (IMF) joint initiative to prepare Reports on the Observance of Standards and Codes (ROSC). The review focuses on the strengths and weaknesses of the accounting and auditing environment in the corporate sector and how they influence the quality of corporate financial reporting. International Financial Reporting Standards (IFRS) 1 and International Standards on Auditing (ISA) 2 were used as benchmarks for this assessment, which included both statutory requirements and actual practices. 2. Paraguay is a landlocked country of 400,000 km 2 and 6 million inhabitants. It functions as a small, open economy. Reliance on the country s primary resources without resort to protectionism was among the factors that enabled Paraguay to avoid the extreme macroeconomic instability, including hyper-inflation, experienced elsewhere in Latin America over the past 50 years; but as a result, the country s economic activity still relies mainly on agriculture, informal trade, mainly with Argentina and Brazil, and, since the late 1970s, hydroelectric power generation. 3. In 1989, Paraguay emerged from 35 years of authoritarian rule, burdened with a complex legacy of debilitated institutions, a dwindling stock of human capital and a severe lack of transparency in many of the country s public and private sector institutions. More importantly, poverty and inequality remained as defining characteristics of Paraguay s economic and social landscape. In 2002, 16.4 percent of the population was living with less than $1 a day while the country s Gini coefficient, a measure of income distribution, stood at 0.58, one of the lowest in the region. 3 This scenario is further exacerbated by the perception both inside and outside the country of pervasive corruption and lack of rules. International surveys and research conducted at multilateral institutions have highlighted this issue. A recent example is the WB s 2005 Country Policy and Institutional Assessment, which ranks Paraguay 24 out of 28 countries in the region in its overall rating. 4. In August of 2003, President Nicanor Duarte Frutos took office after an electoral process that was viewed as the best since At the outset, the new government garnered broad political support around a reform package that included a specific legislative agenda. Following his inauguration, the economic team negotiated a stand-by agreement with the IMF, the first since 1958, and obtained emergency financing from the WB and the Inter-American Development Bank (IDB). As a result of these actions, the country s macroeconomic situation began to stabilize, and a default scenario was averted. 5 Preliminary figures for 2005 show a positive fiscal balance for a second consecutive year and improvements in the government s efficiency. 6 Nevertheless, a high priority is still assigned to broadening the country s tax base, which at 12 percent of GDP is still small compared with the rest of Latin America. The IFRS correspond to the pronouncements issued by the International Accounting Standards Board (IASB) and International Accounting Standards (IAS) issued by its predecessor, the International Accounting Standards Committee, as well as related interpretations. These are issued by the International Auditing and Assurance Standards Board within the International Federation of Accountants (IFAC). World Development Report 2006, The WB. Pages 278 and 279. Data available for 20 countries. Only Bolivia and Brazil show lower indices than Paraguay. Electronic voting was introduced for 45 percent of registered voters and election results for this group were known less than an hour after the polls closed. Also significant was the rescheduling of US$ 138 million of government bonds placed with local banks. Revenue collection increased by 41% in 2004 and an additional 12% in In addition, the number of registered taxpayers has increased by 15 percent. Paraguay ROSC Accounting & Auditing 1

13 improvement of public sector governance remains a high priority as well. A successor stand-by agreement with the IMF was under negotiation at the time this report was prepared. 5. Paraguay is a member of Mercosur, the regional economic zone established in 1991 with Argentina, Brazil and Uruguay, 7 however, the country is seeking to expand its economic ties with other partners. So far, Mercosur has made limited progress in becoming the rules-based common market it aspires to be. This has made the integration of the two smaller economies, Uruguay and Paraguay, particularly difficult. Nevertheless, it is widely recognized in Paraguay that Mercosur is a reality and that regional integration is desirable. Beyond Mercosur, Paraguay has been seeking closer commercial links with the US - currently its third largest market - and Europe. 6. Paraguay s financial sector has been experiencing stability after almost eight years of recurrent crisis. Starting in 1995 and culminating in 2002 with the collapse of Banco Alemán, 8 the number of banks and financieras 9 dropped from 99 to 27. Estimates of the amount of non-recovered Central Bank liquidity assistance and payments made under the state deposit guarantee scheme related to these banking industry failures range between 10 percent and 12 percent of 2002 GDP. 7. Banks remain the predominant players in the financial sector, with 77 percent of the aggregate financial assets and 70 percent of aggregate loan portfolios. Financieras (FINs) and credit cooperatives (CACs) make up the rest. An important issue in the banking sector is the rapid segmentation of the market. Banks, especially the 11 that are foreign-owned, have significantly scaled down retail operations and focused instead on large corporate clients in the export sector. In turn, retail credit operations have moved to FINs and CACs, whose portfolios have shown greater dynamism. The growing significance of CACs in the financial sector is an issue of particular importance in Paraguay. Both banks and FINs have lost significant ground to CACs, which now hold 14.2 percent of the financial assets and 19.5 percent of loans. Including production cooperatives, which also do significant lending, the cooperative sector s share of loans reaches 25 percent. Paraguay s private sector still suffers from limited access to credit. Loan to deposit ratio in the financial system is 58 percent, down from 84 percent before the crisis. The insurance sector is characterized by an unusually large number of companies (35), most of them local. Total insurance premium income in 2005 amounted to US$120 million approximately, which means that some level of consolidation is expected in the near future. 8. As in a majority of countries in Latin America, the stock market still plays a limited role in Paraguay. Trading at the Asunción Stock and Commodities Exchange (BVPASA) remains very low at 0.41 percent of GDP. Market capitalization of $212 million is also low at 3 percent of GDP. However, the market has shown signs of progress in the last 2 years, trade volume has tripled between 2003 and 2005, and half of the 60 listed companies made offerings of equity or fixed income securities. 10 The lack of institutional investors is the main reason why the market remains embryonic. The insurance sector is very small by all standard measures. 11 There Treaty of Asunción signed on March 26, Second largest bank in the country, part of the Argentine-Uruguayan conglomerate Grupo Velox and a casualty of the Argentine economic crisis. These are essentially savings and loans companies providing the same services as commercial banks, with the exception of checking accounts and some aspects of foreign trade. Listed companies were granted several incentives, such as income tax holiday for up to 5 years, by laws drafted to promote capital markets. However, the fact that most large companies are still family owned, coupled with the lack of liquidity in the market, has kept the bulk of Paraguay s corporate sector outside the exchange. Premium income as a percentage of GDP is 0.96 percent, and there is no real depth or density. This small market is shared among 35 companies, a highly fragmented industry with no capacity to provide liquidity to the market. Paraguay ROSC Accounting & Auditing 2

14 is also a need for new and comprehensive regulatory framework in the pension sector; this is emphasized in the WB s Country Assistance Strategy, and in the IMF stand-by agreement s structural reform agenda. The recent financial difficulties experienced at the banking sector pension fund (Caja Bancaria) highlight the fragility of the system, where benefits are paid from the current contributions of active workers, and explain the pension fund system s negligible impact on the development of local capital markets. 9. State-owned enterprises (SOEs) cover key sectors of Paraguay s economy and account for an estimated 30 percent of public sector expenditures. The main SOEs include Administración Nacional de Electricidad, Petróleos Paraguayos, Empresa de Servicios Sanitarios del Paraguay (water and sanitation), Compañía Paraguaya de Comunicaciones (which has a monopoly on land lines), and Industria Nacional del Cemento. The development of a plan to allow participation of public capital in key public enterprises was set as a performance criterion in the country s stand-by agreement with the IMF which expired in November of As of the date of this report, this plan was still under preparation, pending the conclusion of external audits performed at Paraguayan SOEs on a one-time basis. A successor arrangement was approved by the IMF Board of Directors on May 30 and it also stresses the need for improved governance in the country s SOE s. In any event, the government needs to have adequate tools to (i) continuously monitor the performance of these companies and (ii) ensure an appropriate level of managerial accountability. 10. Improving financial reporting and auditing practices and effectively aligning them with international standards will support Paraguay s efforts to increase private investment thereby promoting sustainable economic growth. The long-term benefits associated with improved corporate accounting and auditing practices include: An enhanced business climate A business climate that fosters investor confidence and thus can attract foreign or domestic investment requires a high level of financial transparency on the part of private or state-owned companies operating in the domestic markets, and the observance by these companies of sound practices of accountability and governance. These requirements imply a financial reporting regime that provides investors, creditors and other third parties with timely and accurate information for their investment and other business decisions. Increased transparency in the economy One of Paraguay s priorities includes improving the overall image of the country with regards to transparency and the fight against corruption. The recommendations of this ROSC can contribute to this stated goal by both the public and the private sector in Paraguay. Reduced risks in the financial sector The banking sector s ability to assess credit risks properly depends largely on the accuracy and reliability of corporate financial reporting. Improving the quality of the financial information provided by enterprises therefore contributes to mitigating the risks for banks and other lenders. In the current circumstances, better and timelier financial information from borrowers can ease liquidity constraints in the banking system. Greater economic integration on regional and international levels Perhaps most important, by observing financial practices similar to those of its main economic partners and aligned with internationally accepted standards, Paraguay will enhance its ability to integrate its economy in regional and international markets. Paraguay ROSC Accounting & Auditing 3

15 Improve governance within the State- owned enterprise sector Improving the financial reporting regime applicable to SOEs will help the government to adequately monitor a crucial sector that covers key areas of economic activity in the country. Capital market development Paraguay s securities market has been growing over the last three years. Yet further growth and development will require greater confidence on the part of investors, and this can only be achieved if the company financial reporting regime which investors rely upon when making investment decisions can be regarded as timely and accurate. 11. In this context, the ROSC Accounting & Auditing in Paraguay seeks to support the following three strategic objectives: a) Make the business environment more attractive for domestic and foreign direct investment; b) Improve transparency and accountability in the country s corporate sector including SOEs; and c) Enhance opportunities for better economic integration with the region and the world. II. INSTITUTIONAL FRAMEWORK FOR CORPORATE SECTOR ACCOUNTING AND AUDITING A. Statutory Framework 12. Overall, the statutory framework for accounting and auditing is fragmented and lacks rules and coherence. This makes professional practice in the country difficult and entails unnecessary duplication of effort on the part of both the public and private sectors. A large segment of Paraguay s corporate sector operates in an environment where no legally sanctioned standards exist. In the supervised sectors, where for the most part adequate rules are in place, different accounting, auditing and financial reporting standards apply. Table 1 Summary of accounting and auditing requirements by types of entities. Type of Regulatory Accounting Audit Requirement Publication Entity Agency Standards Bank BCP/SIB BCP-SIB regulations Yes, by SIB-registered auditor In gazette / newspaper not Insurance Company BCP/SIS BCP/SIS regulations Yes, by SIS-registered auditor available electronically Listed Company CNV CNV regulations Yes, by CNV-registered auditor On CNV's website Cooperative INCOOP INCOOP Regulations Yes, for Type A Coops, by INCOOP registered auditor Planned for 2007: on INCOOP's website SOE CGR None mandatory None required Not required Non-Listed Company n/a None mandatory For companies with bank borrowings 3 million Not required Paraguay ROSC Accounting & Auditing 4

16 A.1 Accounting 13. Paraguay s commercial code (Ley del Comerciante, 1983) establishes basic obligations regarding accounting. Companies, including sole proprietorships, with equity in excess of 1,000 daily minimum wages 12 must carry proper and regular accounting books. The number of books and the system of accounting is left to the entrepreneur s judgment with the exception of a daily ledger and an inventory book which are mandatory. 14. Tax legislation sets additional requirements for financial reporting by companies subject to corporate income tax. 13 Article 189 of Law 125/1991, New Tax Regime, includes a broad mandate, giving the MoF s authority to issue regulation on accounting practices, documentation and registration by companies and individuals subject to taxation. This article constitutes the base for Resolution 173 issued in June of 2004, which was a significant step towards improving financial reporting by companies in Paraguay. It became effective in December of the same year, and with the exception of the notes to the financial statements, it requires the preparation and filing of all components as provided in International Accounting Standard (IAS) Previously only a specific tax form (balance fiscal) summarizing the company s balance sheet and income statement was required. 15. Later in 2004, Law 2421 of Administrative Reorganization and Fiscal Adequacy was enacted to modify the tax regime. This law aims at fighting informality. It introduces personal income tax in the country, significantly lowers corporate income tax (from 30 percent to 10 percent) and broadens MoF s authority to set accounting standards. Its regulatory Decree 6359 issued in September of 2005 states that the tax administration, through General Resolutions, may include within the regulatory framework, International Financial Reporting Standards and other Generally Accepted Accounting Principles, as long as they do not conflict with dispositions in the tax law and this decree. As of the date of this report, the implementation of these new standards was still in the planning stage. 16. As usual elsewhere in Latin America, accounting and auditing in the banking and insurance sectors in Paraguay are governed by specific statutes. In the case of Paraguay, there are two other sectors whose accounting standards are set by specific regulatory agencies. The National Securities Commission (CNV) is the standard setter for listed companies, and the National Institute of Cooperatives (INCOOP) regulates cooperatives. 15 Statutes in place for each of the four sectors mandate the use of IAS/ IFRS, 16 but only as a complement to the local standards, and in case of conflict local standards take precedence. 17. Banking laws and regulations provide a clear and comprehensive framework for accounting practices within financial institutions. The accounting framework is in the process of being strengthened with a view to gradually converging with the Basel II principles of supervision. In terms of accounting basis, banks and other financial institutions are required by law to apply the Banking Superintendency s accounting manual and related regulations for both As of June 2006, approximately US$7,000. According to Decree 1400/92 these include all type of commercial enterprises as defined by the Law of Commerce as well as all state-owned enterprises. The five components are: (i) balance Sheet, (ii) income statement, (ii) statement of changes in equity, (iv) cash flow statement; and (v) notes, comprising a summary of significant accounting policies and other explanatory notes. This report defines the supervised cooperative sector as the 45 largest cooperatives classified as type A,` which are subject to the full regulatory framework imposed by INCOOP. Referencing Technical Resolutions (TR) issued by the Colegio de Contadores del Paraguay. The SIB references TR 1. SIS, CNV, and INCOOP refer to the Colegio s TRs in general. Paraguay ROSC Accounting & Auditing 5

17 prudential and general-purpose reporting (i.e. a single set of statements is prepared for both purposes). 17 Because of its primarily prudential focus, the accounting manual differs significantly from IFRS which is mainly geared towards investors. A discussion of the nature of these differences and their implications is provided in Para. 47. With respect to reporting, financial institutions must file with SIB and publish their annual financial statements within 120 days after year-end and a full set of financial statements no later than 10 days after the close of each quarter. 18 Financial institutions must use the calendar year as their fiscal year. 18. CNV Resolution 5 issued in July 1992 establishes accounting regulations for listed companies based on International Accounting Standards effective at the time. It requires the preparation and filing of all basic financial statements and a specific set of disclosures that includes statistical information and ratio analysis, breakdown of costs and expenses, composition of plant, property and equipment and foreign currency assets and liabilities. Listed companies must file with the regulators and the exchange quarterly financial statements signed by management and the internal control officer or síndico (see Para. 27 below). Annual financial statements must be filed with CNV no later than 110 days after year-end and must include an external auditor s report. Efforts are currently underway to update Resolution 5 and to strengthen CNV regulations. 19. Cooperatives must comply with a special statutory framework which has been revised and updated extensively since the creation of the regulatory agency in The General Regulatory and Supervision Framework for Cooperatives is comprehensive and follows a prudential approach, similar to the one in the banking sector. Regulation follows a three tiered approach. The 263 cooperatives in operation are classified into three categories (A, B and C) according to their level of assets, deposits, other liabilities, equity and number of members. The 45 cooperatives in the top tier are subject to the most exacting set of rules, and allowances are made to accommodate the characteristics of smaller cooperatives. Financial reporting is done using a mandatory chart of accounts. Financial statements from cooperatives must be filed annually with INCOOP. A.2 Auditing 20. Banks and other financial institutions are required to obtain audited financial statements from their large corporate clients. The relevant section of Resolution 8, issued by SIB in 1996 applies to companies with aggregate borrowings of US$3 million 20 or more, or above US$1 million with any single financial institution. A new SIB resolution which will become effective in 2008 lowers the overall threshold to US$2.4 million and the single entity threshold to US$0.6 million. 21 To access this segment of the market, audit professionals or firms are only required to be licensed professionals with an enabling academic degree Banking Law (no. 861/96), Art Detailed requirements are set in SIB Resolution no. 13/94 (Plan y Manual de Cuentas del Sistema Financiero). Banking Law, Art Art. 106 also requires the SIB to publish every quarter a set of financial indicators regarding financial institutions operating in Paraguay. Finally, SIB Resolutions no. 723/95 and 514/96 set a compulsory format of financial statements for annual and quarterly reporting, respectively. Cooperative Law 438/94 and regulatory decree 14052, Law 2157/03 which creates the regulatory agency mentioned in Para. 16, and resolution 499/04. Resolution 360/04 modified by resolution 1090/05 provides a mandatory chart of accounts. The Central Bank s Risk Central consolidates information only from Banks and Finance Companies, so the threshold is applicable to transactions with these institutions. The new thresholds are indexed to the monthly minimum wage, which currently stands at US$214. Paraguay ROSC Accounting & Auditing 6

18 21. All five existing regulatory agencies have issued sector-specific regulations regarding the registry of external auditors. The CGR registry only sets entry requirements and does not regulate or monitor professional practice. All other registries have written policies regarding independence and definitions of what constitutes a related party. They require periodic information on the composition of the firm s revenues and mandate access to the auditor s working papers for a period of five years after the date of the report. They also set provisions regarding infractions and sanctions. SIB and SIS manuals regarding accounting practice are very detailed and comprehensive. On the other hand, none of them require professional examination as an entry requirement, and only CNV mandates continuing professional development. 22 In all cases, ISA are mentioned as complementary to regulations issued by the respective agency. Mandatory rotation of audit firms is already effective in the banking sector. Rotation of audit firms will soon be applicable also to companies regulated by the SIS, the CNV and INCOOP, after 3 years (2 years for cooperatives). These various requirements are summarized in Table 2. Table 2 Requirements for Registration as External Auditor Sector Academic Level Professional Experience Rotation Term of Registration Banking 4 years None Periodic Firm, 3 evaluation years, 1 Insurance 5 years for year 2 years College partners, 3 cooling off degree in years for firm Securities market Cooperative SOE Accounting 3 years Firm, 3 years, 2 years cooling off None Periodic evaluation Auditing Standards Combination of ISA, Colegio s and sectorspecific standards College degree in Accounting Economics 5 years (for signing partner) Firm, 2 years, 1 year cooling off 2 years Colegio s and sector-specific standards or Business 5 years None specified 22. The reformed tax code establishes mandatory audits for companies with revenues equal or above US$1 million, 23 with the possibility of extending this obligation to other categories of taxpayers. This law is expected to affect a larger number of companies than the banking audit regulation. Moreover, the new tax code, Article 33, states that the tax administration is to establish a registry of external auditors, with similar functions and objectives to the ones currently in place in the supervised sectors. 24 This provision had not been implemented as of the date of this report. 23. External auditors of financial institutions must be licensed by SIB and must adhere to specific standards on auditing and professional conduct. The conditions for an audit firm or individual auditor to be qualified by the SIB and the auditing and ethical standards to be applied by that firm of individual are set out in the Manual of Norms and Regulations for an Independent 22 Minimum 20 hours per year on market-related issues. 23 The Law grants the tax administration the authority to update this amount annually. 24 In their comments to the ROSC, the Tax authorities made reference to Resolution No 113 which requires certain tax payers to present a Report of Tax Payment that must be emitted by an external independent auditor. Paraguay ROSC Accounting & Auditing 7

19 Audit in a Financial Institution (Manual on Independent Audit) issued by SIB through Resolution no. 313/91. The manual is very comprehensive, covering all key aspects ranging from qualification to standards of audit work. Salient features of SIB s Manual on Independent Audit are presented in Box External audit activities in the insurance sector are thoroughly regulated by SIS Resolutions 241/04 (on the qualification of audit firms and individual auditors) and 242/04 (on auditing standards and reporting). The two resolutions combined are broadly equivalent to the corresponding regulations on auditing issued by SIB for the banking sector (see Para. 23), although certain differences exist, relating in particular to: (i) sectoral expertise, which is not mandatory for would-be auditors of insurance companies (although it accounts for 10 percent of the total grade as part of the scoring system); (ii) contrary to SIB, SIS cannot refuse registration to an auditor as long as they meet the minimum level of the scoring system; (iii) SIS includes the obligation for external auditors to take a liability insurance policy, which is not present in SIB s regulations; and (iv) SIS requires a heavier level of reporting obligations for insurance company auditors. 25 Box 1 SIB s Manual on Independent Audit Salient Features External auditors must be qualified by the SIB. In addition to the usual requirements of probity and absence of ex-ante conflicts of interests, the qualification process is based on a scoring system in the four main areas of (i) independence, (ii) professional education, (iii) quality and experience, and (iv) institutional capacity. 26 This system is more sophisticated than most qualification mechanisms adopted by banking or insurance supervisors, covering all key aspects required to evaluate a would-be auditor s ability to fulfill each function. Moreover, the weight of each of the four areas seems appropriate given that actual experience of the banking sector is critical for an auditor to operate effectively. The qualification system is two tiered, with Category I firms and individuals authorized to conduct audits and related services, whereas Category II firms and individuals can only render related services (i.e. cannot issue an independent audit report). Once qualified, the firms or individual appears on the SIB s Registry of Independent Auditors, which can be accessed by the public. As of the date of this report, 23 audit firms were registered under Category I and 3 individuals were registered as Category II. One application by an individual was pending review. Even though the qualification is based on an objective assessment, the SIB retains the possibility to reject an application at its discretion, which is consistent with its role as supervisor. External auditors appointment must be approved by the audit committee. The process for selecting a bank s independent auditor from the SIB registry requires obtaining bids from at least two firms and the endorsement of the bank s audit committee. Banks must set up an audit committee as part of the regulations regarding internal controls; the audit committee is a committee of the board of directors and must include at least two board members with no executive functions. 27 The way the audit committee should interact with the corporation s internal control officer (síndico) is not defined Separate audit reports are required on (a) the financial statements, (b) solvency ratios, (c) follow-up on prior audits recommendations, (d) internal controls, (e) evaluation of accounting system, (f) compliance with laws and regulations, (g) tax compliance and (h) information technology system. A fairly detailed explanation of what the criteria for evaluating the auditors are, and how scores are assigned, is provided in the Manual on Independent Audit. The full text of the Manual / Resolution no. 313/91 can may be accessed at SIB Resolutions nos. 455/99 and 256/2000. Paraguay ROSC Accounting & Auditing 8